Portfolio too aggressive for Jack's age

Suggestion is to dial down the risk

BY ANDREW ALLENTUCK
This is a new feature for Globe Investor Magazine in which the writer asks an expert to review an anonymous reader's portfolio and provide suggestions for how to fix it. The reader can then take the suggestions as he or she sees fit.Globe Investor Magazine, May 04, 2009

The Problem:
A retired Toronto businessman we'll call Jack, 79, has watched his portfolio of mutual funds shrivel from $1,348,000 in the summer of 2008 to a recent value of $856,200 - a 36.5-per-cent loss. Funds that were once stars have become what seem to be flops. He has put his faith in their management, for he has no stocks outside of them.
"I have been a strong fan of certain mutual funds. But in this recession, I have taken quite a hit in equity and dividend funds. Now I feel that I must do something different for my remaining years and provide something of an estate for my family."
We asked Dan Hallett, a mutual fund expert who heads investment advisory and research firm Dan Hallett & Associates in Windsor, Ont., to work with Jack. As he sees it, Jack has a good chance of running out of money before he reaches age 90.

How the portfolio stacks up:
Currently, the annual sum of Jack's estimated investment income is $9,672; his corporate pension, $28,072; Canada Pension Plan benefits, $9,861; Old Age Security, $6,204; plus RRIF withdrawals of $46,027, for a total of $99,836. He pays $34,532 in tax, including a nearly complete clawback of OAS benefits, and is left with $65,304. To that he adds $44,338 from his non-registered investments, for a total of $109,642, which, after capital gains taxes, covers his $100,000 annual cost of living.

The portfolio issue is not so much loss of principal in the recent market decline, which may be more than compensated by future gains in value, but the problem that Jack is taking out 11.8 per cent per year from his assets while generating returns which, over the last three decades of the asset classes in which he is currently invested, have been 8.2 per cent. That is an extrapolation from history; Jack's short-term returns in future are likely to vary from this average, Mr. Hallett notes.

The historical returns of the portfolio have indeed been quite variable. Mr. Hallett calculates that the portfolio has lost money in 23 per cent of years and gained less than 5 per cent in a third of all years.

"If we assume that the withdrawal rate is 11.8 per cent and that the portfolio has an average real rate of return of 3 per cent, then there is a 52-per-cent chance he will run out of money before he reaches age 90," Mr. Hallett says.

Non-Registered:
$322,400 PH&N Dividend Income FundPortfolioTotal: $856,200What our expert suggests:
Jack's portfolio is 72 per cent equity funds with 54 per cent Canadian stocks, 18 per cent U.S. stocks; 25 per cent bonds and 2 per cent cash. That is rather aggressive for an investor who has a goal of producing regular cash flow. "I would suggest that his risk exposure needs to be dialled down a bit," Mr. Hallett says. "I hate to do that when stock prices are so low. But it has to be done."

Raising fixed-income content would make it possible for Jack to achieve a pre-tax portfolio return of at least 4 per cent. That rate of return will sustain his withdrawals to his age 90, Mr. Hallett adds.
The portfolio rebalancing would move some capital to exchange-traded funds.

Results of the Switches:
These trades would reduce annual management fees (MERs) to between 24 and 40 basis points for the ETFs from a range of 1.05 per cent to 2.26 per cent of net asset value for Jack's mutual funds. There are 100 basis points in one percentage point.

The shift to ETFs will make each fund entirely dependent on a market index. Jack will still have exposure to equity growth through the foreign stock funds. The foreign funds are hedged to Canadian dollars, eliminating currency risk.

On top of existing fixed-income holdings in the TD Canadian Bond Fund, several bond strips and Canada Savings Bonds, the switch will raise Jack's total fixed-income allocation to 58 per cent of his total portfolio.

For an investor like Jack, who is accustomed to running his own portfolio, the strategy has a good chance of raising returns. He will not have to research stocks and he can be free of worries that a change of fund management will affect his returns. Index funds, after all, have no active management. But he will have to monitor portfolio values to ensure that he is not trading off performance for lower costs.

The Outlook:
"Ordinarily, I would not suggest that an investor put so much faith in ETFs, but Jack wants to run his own portfolio," Mr. Hallett says. "In this case, a portfolio heavily weighted with ETFs suits the client."